THE JOURNAL OF FINANCE * VOL. XXXVIII, NO. 1 * MARCH 1983 Year-End Tax-Induced Sales and Stock Market Seasonality DAN GIVOLY and ARIE OVADIA* ABSTRACT The paper relates two phenomena in the stock market:the high return during the month of January and the apparent existence of widespreadsales of stocks for tax purposestowardsthe end of the fiscal year. The findingssuggest that, due to the tax- induced sales, the priceof many stocks over the last 35 years was temporarily depressed in December but recoveredin the following January.This price recovery is a major contributor to the high returnsobservedin January.The tax effect is present in firms of all sizes but much more pronounced for small firms.The analysis also indicatesthat a more precise identificationof the tax-switch candidates may prove that the tax- inducedsales are, in fact, the sole contributor to the high January's returns. THE ISSUE OF SEASONALITY in the stock market has attracted the attention of researchers for some time. Rozeff and Kinney [13] present evidence of seasonality in the market index with the months of January and July having a peak return. The seasonal movements in the average return in the market could not be fully accounted for by a corresponding seasonal pattern in the market risk. They offer three explanations to this phenomenon: tax-induced sales, release of accounting information, and seasonal demand for cash. The first explanation has received some support from recent research. Dyl [4] studied the effects of capital gain taxes on trading volumes of common stocks and concluded that "capital gain taxes affect investors' year-end portfolio decisions, and that this effect is, in turn, reflected in the trading volumes of common stocks in December" (p. 174). McEnally [10] and Branch [2] studied the effects of the tax-induced trading on securities return and found that depressed stocks at the end of the year are likely to bounce back immediately after year-end. The existence of a pronounced seasonal behavior in the market might suggest some form of market inefficiency: a strategy under which stocks are bought towards the end of the year and sold at the beginning of the following year might yield an abnormal return. Despite the seasonal behavior of stock returns, it would be indeed surprising if this regularity, which has not gone unnoticed by the financial community, could be exploited to bring a risk-adjusted excess return. The objective of this paper is to examine jointly the two phenomena: tax- * Facultyof Management, Tel Aviv Universityand the Graduate School of Industrial Administra- tion, Carnegie-Mellon University; and Facultyof Management, Tel Aviv University and the Graduate School of Business Administration, Temple University.The authors wish to thank Robert Kaplan, Josef Lakonishok, Richard McEnally, Joshua Ronen, Pete Wilson, and an anonymousreferee for their helpful comments. The competentprogramming assistanceof SharadSinghal and Navin Tyle are gratefully acknowledged. 171